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Animal Spirits and Monetary Policy

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  • Paul De Grauwe
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    Abstract

    We develop a behavioral macroeconomic model in which agents use simple but biased rules to forecast future output and inflation. This model generates endogenous waves of optimism and pessimism (“Animal Spirits”) that are generated by the correlation of biased beliefs. We contrast the dynamics of this model with a stylized DSGE-version of the model and we study the implications for monetary policies. One of our main results is that strict inflation targeting is suboptimal because it gives more scope for waves of optimism and pessimism to emerge thereby destabilizing output and inflation.

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    File URL: http://www.cesifo-group.de/portal/page/portal/DocBase_Content/WP/WP-CESifo_Working_Papers/wp-cesifo-2008/wp-cesifo-2008-10/cesifo1_wp2418.pdf
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    Bibliographic Info

    Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 2418.

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    Date of creation: 2008
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    Handle: RePEc:ces:ceswps:_2418

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    Related research

    Keywords: DSGE-model; imperfect information; heuristics; animal spirits;

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    References

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    1. Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers 99-13, C.V. Starr Center for Applied Economics, New York University.
    2. Arturo Estrella & Jeffrey C. Fuhrer, 2002. "Dynamic Inconsistencies: Counterfactual Implications of a Class of Rational-Expectations Models," American Economic Review, American Economic Association, vol. 92(4), pages 1013-1028, September.
    3. George Evans & William Branch, 2003. "Intrinsic Heterogeneity in Expectation Formation," Computing in Economics and Finance 2003 312, Society for Computational Economics.
    4. Jess Benhabib & Roger E.A. Farmer, 1992. "Indeterminacy and Increasing Returns," UCLA Economics Working Papers 646, UCLA Department of Economics.
    5. Brock, W.A. & Hommes, C.H., 1996. "A Rational Route to Randomness," Working papers 9530r, Wisconsin Madison - Social Systems.
    6. Fabio Milani, 2005. "Expectations, Learning and Macroeconomic Persistence," Macroeconomics 0510022, EconWPA.
    7. Mackowiak, Bartosz Adam & Wiederholt, Mirko, 2007. "Optimal Sticky Prices under Rational Inattention," CEPR Discussion Papers 6243, C.E.P.R. Discussion Papers.
    8. Jordi Galí & J. David López Salido & Javier Vallés, 2003. "Rule-of-thumb consumers and the design of interest rate rules," Banco de Espa�a Working Papers 0320, Banco de Espa�a.
    9. De Long, J. Bradford & Shleifer, Andrei & Summers, Lawrence H. & Waldmann, Robert J., 1990. "Noise Trader Risk in Financial Markets," Scholarly Articles 3725552, Harvard University Department of Economics.
    10. Svensson, Lars E.O., 1997. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," Seminar Papers 615, Stockholm University, Institute for International Economic Studies.
    11. Alexis Anagnostopoulos & Italo Bove & Karl Schlag & Omar Licandro, 2006. "An Evolutionary Theory of Inflation Inertia," Working Papers 2006-25, FEDEA.
    12. Nelson, E., 1998. "Sluggish inflation and optimizing models of the business cycle," Journal of Monetary Economics, Elsevier, vol. 42(2), pages 303-322, July.
    13. Azariadis, Costas, 1981. "Self-fulfilling prophecies," Journal of Economic Theory, Elsevier, vol. 25(3), pages 380-396, December.
    14. Roger E.A. Farmer & Jang Ting Guo, 1992. "Real Business Cycles and the Animal Spirits Hypothesis," UCLA Economics Working Papers 680, UCLA Department of Economics.
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    Cited by:
    1. de la Torre, Augusto & Ize, Alain, 2009. "Regulatory reform : integrating paradigms," Policy Research Working Paper Series 4842, The World Bank.
    2. Branch, William A. & McGough, Bruce, 2010. "Dynamic predictor selection in a new Keynesian model with heterogeneous expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 34(8), pages 1492-1508, August.
    3. John Knight & Sai Ding, 2010. "Why Does China Invest So Much?," Asian Economic Papers, MIT Press, vol. 9(3), pages 87-117, October.
    4. Mikhail Anufriev & Tiziana Assenza & Cars Hommes & Domenico Massaro, 0000. "Interest Rate Rules and Macroeconomic Stability under Heterogeneous Expectations," Tinbergen Institute Discussion Papers 09-040/1, Tinbergen Institute.

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